Evaluating Risk Like a Hedge Fund Manager

In The Psychology of Money, Morgan Housel states, “The only way to deal with [uncertainty, randomness, and chance “unknowns”] is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day”

As a self-directed investor, properly quantifying and scoping a portfolio’s risk can feel like a daunting task. In fact, if you just consider the market-changing events of the last few years (including a worldwide pandemic, inflation, and geopolitical crises), it feels more futile than ever.

Luckily, there is one type of professional investor that is a treasure trove of knowledge on managing risk - the hedge fund manager.

In this post, we will discuss three lessons from a hedge fund manager on how they evaluate and optimize risk in their portfolios.

Lesson One: Optimize Differently

A hedge fund manager isn’t always seeking to create a portfolio with the highest possible return. What they are actually optimizing for is the return of a portfolio given a certain level of risk.

After all, few investors have the same risk tolerance (nor should they). A wise investor ensures that a portfolio is providing the highest returns, but only within the context of the risk they are willing to take on.

Lesson Two: Diversify Against Macro Drivers

A not-so-secret reality of investing is that the majority of all medium to long term investments’ performance is tied to expectations around growth and inflation.

Informed hedge fund managers take this one step further and check how every security in their portfolio (regardless of asset class) has historically responded to these macro drivers. Ultimately, they seek to create a portfolio of complementary assets that does well in all macroeconomic situations.

Lesson Three: Think Probabilistically

A hedge fund manager does not deal in certainties when it comes to risk management. The economy is a complex web of relationships, and even though there are some models that can make sense of it all, most of that information is held deep within secretive institutions.

A prudent investor is always thinking about protecting their downside, and ensuring that their portfolio isn’t comprised of assets that all respond the same way to the underlying factors.

If these three lessons were helpful, check out our 5 Secrets to Thinking Like a Hedge Fund Manager for more ideas on how to evaluate risk and help optimize your portfolio.